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Dividends: Not Just for Retirees Anymore

With the death of the bull market, many are rediscovering the beauty of dividend-paying stocks.

You can blame it on the Fed's vigilance against inflation. Or you can chalk it up to our tax laws. Or you can trace it to the move toward stock option-based compensation, which has forced companies to commit excess cash to buy shares for option grants. No matter what the culprit, it's a plain fact that dividends are getting harder to come by. Fewer companies offer them, and the average dividend yield is now 1.4 percent, down from 4.5 percent in 1980.

The lower dividend yields are partially the result of today's low-inflation environment. With CDs offering less than a 2 percent yield, corporations know they don't have to worry about juicing their dividend to make their stock competitive for income-oriented investors. And since dividends are doubly taxed (at the corporate and personal level), few investors have complained about the income component's decline.

The picture may be changing, however, thanks to the bear market. After witnessing two straight losing years, many investors — and not just retirees — are revisiting the relative security of dividend paying stocks. “We've been getting a lot of interest again from our clients lately,” says broker Elizabeth Rivera, who heads up the Dallas office for Stephens Inc.

So, where can you turn to find the right income-paying stocks for your clients? It depends on their needs. For those in need of a modest amount of income, many growth stocks offer steady income with the promise of future growth. As Table I shows, you can find a wide range of stocks that offer a decent yield, with expectations of higher dividends.

Take regional bank Compass Bancshares as an example. Five years ago, the company's stock traded for $15 and sported a 57 cents a share annual dividend. That dividend is now 92 cents, for an equivalent 6.1 percent yield when compared to the original basis cost of the stock. And in that time, shares of Compass have doubled. Over time, the gains are even more impressive. If you bought shares of Eaton Vance or MBNA 10 years ago, you'd currently be getting an 18 percent dividend yield on the original basis price.

If your clients are looking for a combination of a decent yield combined with the potential for growth, they may want to check out utility stocks. These companies, which were once the province of widows and orphans, cut their dividends in the late 1990s to redirect cash into newer ventures in a dubious bid to diversify, like the Williams Cos.

But David Harris, a senior vice president at Salomon Smith Barney, thinks utilities have learned their lessons. “Many of them are going back to the basics instead of foolishly chasing new growth areas,” he says. Harris thinks many utilities are due for hikes in their payouts, since earnings have increased while dividends have not. And judging by industry payout ratios, which now hover in the 60 percent to 65 percent range, utilities have ample room to hike their dividends just to return to historical payout ratio norms of 75 percent to 80 percent.

Of course, other investors are looking for income from current investments and are not as concerned about growth in share prices and dividend payouts. For these folks, REITS and limited partnerships are a better choice. These entities typically pay out almost all of their cash flow in the form of a dividend. And in most cases, these dividends aren't taxed at the corporate level, removing half of the double-taxation burden. As Table II shows, it's not hard to find 7 percent to 9 percent yields.

Table I: Modest Yields With Long-Term Promise
Ticker Name Dividend Yield 5 Yr. Div. Growth Rate % TTM Payout Ratio Market Cap. ($bil)
UST UST 5.33 6.25 61.66 5.70
UPC Union Planters 4.48 15.34 62.21 6.13
WMB Williams Cos. 4.44 10.76 32.09 9.28
ASO AmSouth Bancorp 4.29 12.16 57.81 7.48
NCC National City 4.24 9.56 50.48 16.88
PNW Pinnacle West Capital 4.03 9.03 38.85 3.36
UTR Unitrin 3.96 8.45 25.26 2.72
BAC Bank of America 3.89 14.65 52.96 97.01
RGBK Regions Financial 3.75 10.35 49.09 7.04
FMER FirstMerit 3.60 11.02 48.24 2.26

REITs also bring the benefit of portfolio diversification. The sector barely budged in 1999 while the S&P 500 was zooming ahead. But REITS, on average, surged 26.65 percent in 2000, according to Morningstar, while the broader averages slumped. The REIT sector advanced an additional 10 percent in 2001 while other sectors meandered. Of course, by that logic, one could conclude that REITs may be fully valued and may sell off if the broader market rebounds. If the economy stays weak, REIT investors are vulnerable to falling real estate prices.

The Preferred Choice

Stephens Inc.'s Rivera suggests brokers also give preferred stocks a look. These stocks usually sport a high yield but are riskier. They tend not to appreciate as much as the company's common stock and their dividends, if the company hits a hiccup, are usually the first to be deferred or cancelled. In addition, preferreds can be called in early, ending that juicy stream of payouts. “[Clients] should know that these dividends are not guaranteed. If they need a guaranteed income stream, they should buy CDs,” she says.

But some brokers express caution when going for higher-yielding stocks. “I talk a lot with my clients about stretching for yield,” says Peter Calfee, president of Cleveland, Ohio-based Calfee Financial Advisors. He figures that investors don't always understand that higher yields can bring higher risk. “So if you reconfigure a client's portfolio for higher income, you have to reassess its beta,” he adds.

Table II: Limited Partnerships And REITS Pay Well

Yield Growth Rate % Cap. ($bil)
HPT Hospitality Properties 9.47 28.61 1.87
PPS Post Properties 9.18 9.18 1.25
HIW Highwoods Properties 8.80 4.86 1.41
FR First Industrial Realty 8.79 5.73 1.21
CEI Crescent R.E. Equities 8.63 15.94 1.89
NXL New Plan Excel Realty 8.62 3.41 1.67
DQE DQE 8.46 6.01 1.12
HCP Health Care Property Inv. 8.31 6.15 2.15
HR Healthcare Realty Trust 8.16 4.03 1.20
LRY Liberty Property Trust 7.97 6.38 2.17
CLI Mack-Cali Realty 7.97 7.47 1.77
EEP Enbridge Energy Partners 7.97 6.13 1.49
NBP Northern Border Partners 7.95 3.79 1.58
DDR Developers Diversified Realty 7.80 5.92 1.05
DRE Duke Realty 7.71 11.31 3.05
ALD Allied Capital 7.66 10.80 2.63
PCL Plum Creek Timber 7.60 3.07 5.50

Those stocks that come with higher yields are indeed more vulnerable simply because they often pay out a greater percentage of profits in the form of a dividend. So if profits fall, so will the dividend. In Table I, we include a column that refers to the payout ratio. This indicates how much net income is being paid out into the dividend. If profits fall for these companies, the payout ratio may rise, but the dividend should still be safe.

To be sure, all dividends can be cut or even eliminated. In recent quarters, Ford Motor, Nortel, United Airlines' parent UAL, Corning and AT&T have all slashed their payouts. A good back-of-the-envelope calculation is to compare a company's earnings per share with its dividend payout per share. If earnings slump below the dividend figure, you can expect a payout cut. (Such firms as Polaroid and Reliance Insurance were so committed to maintaining their dividend in hard times that they eventually went bankrupt.)

Interest rates are the other factor to consider when looking at high-yielding stocks. As interest rates rise, they start to offer comparatively attractive yields with lesser risk. Consequently, dividend-oriented sectors such as utilities tend to sell off when rates rise.

Total Return is the Key

When talking to your clients about dividend-producing stocks, it's important to measure the investment on a total return basis. Investors may have yawned at Philip Morris' 5 percent yield. Or they may have been disappointed in the paltry four percent gain posted by the stock in 2001. But taken together, an investor bagged a more impressive nine percent total return.

In decades past, dividends were a major factor in winning portfolios. In the 1940s, for example, the S&P 500 produced an annualized total return of 9.2 percent, according to Chicago, Ill.-based Ibbotson Associates. About two-thirds of that came from dividends, and the rest from capital gains. In the next decade, strong economic growth resulted in strong capital gains. But in the 1960s the situation reversed back, as dividends constituted nearly half of the total returns.

If the coming decade is characterized by slow growth in corporate profits, a similar trend could play out. “To the extent that the market remains in a ‘value’ orientation, companies will increasingly look back to boosting their dividends,” says Geraldine Weiss, publisher of the newsletter Investment Quality Trends and the book “Dividends Don't Lie: Finding Value in Blue Chip Stocks.” Of course, for that to happen, corporate America will have to lead the charge. Twenty years ago, two-thirds of all companies paid dividends. These days, only 20 percent do. The trend would have to reverse before dividends become a more widespread investment tool.

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